There is a need to benchmark the performance of private equities and other assets and liabilities that have irregular cash flows and also to determine how such an asset or liability would perform under various market scenarios for which actual performance data for the private equity is not available.
A private equity investment has an irregular cash flow. This cash flow comprises draw downs, in which funds are invested into the asset, and disbursements, in which funds are returned to the investor. Cash flow events can occur with long intervening intervals. For example, when there is a slow investment and divestment pace, events may be reported on a quarterly basis, in quarters where investment or divestment events occur. However, as will be appreciated, different private equities operate on different schedules.
There is a desire and need to benchmark the performance of private equity. However, a direct comparison between a private equity and other types of asset classes is difficult. This is because private equity performance is best measured in terms of internal rate of return (“IRR”), due at least in part because of the irregular cash flows, whereas traditional asset classes, such as exchange traded securities, are characterized by time-weighted returns (“TWR”).
A time weighted return provides a measure of the compounded rate of growth of a portfolio's market value during the evaluation period. In contrast, an internal rate of return represents the interest rate at which the net present value the investment, including all cash flows during the evaluation period, equals zero. Because IRR makes use of a present-value evaluation, the value of the IRR is effected by the amount and timing of the irregular cash flow. (For public equity investments, having only one cash inflow and one outflow, the TWR and IRR are the same.)
TWR does not yield useful results for situations with multiple and varying cash in- and outflows. While IRR of private equity normally yields useful absolute performance results, the results cannot be directly compared to the performance of public equities for the same time period, since the level of investments varies for private equities, but not for public equities. For example, the period between 1999 and 2001 was characterized by large run-ups of most equity indexes, followed by a precipitous decline. As can be appreciated, this situation will result in widely different performance comparison depending on the timing of investments and the level of invested funds.
A partial solution to the problem of comparing public and private equity data is provided with a conventional technique known as PME, short for Public Market Equivalent. (PME is also sometimes referred to as ICM or Index Comparison Method.) PME is an index return measure which is adjusted to reflect the irregular timing of cash flows actually experienced with a private equity. A PME corresponds to the dollar-weighted return that would have been achieved by investing in a benchmark public market asset, such as a fund valued on the S&P 500 index, at the same time as when the private equity asset is receiving investment funds and by selling index-shares whenever the private equity asset has a disbursement back to investors.
To determine PME, the cash flows in and out of the private equity asset are applied to an index-based investment at the same time and in the same amounts. Cash inputs to the private equity asset equate to investments in the benchmark asset. Disbursements from the private equity asset equate to sales of the benchmark asset. The IRR for the public fund is then determined based on the total returns for the hypothetical public fund investments at the end of the time period of interest. This value is the public market equivalent IRR for the private equity.
The difference between the PME return of the investment in the benchmark and the IRR for the private equity can be used to compare the performance of the two during the time period for which there is data for the private equity to determine whether or not the private equity outperformed the benchmark. If the PME return is greater than the private equity IRR, the public market, as represented by the benchmark, shows a higher performance. If there is a negative balance, the public market shows a lower performance. PME is described in more detail in various documents, including “A Private Investment Benchmark,” by A. Long, III and C. Nickels, AIMR Conference on Venture Capital Investing, Feb. 13, 1996, and Chapter IX of “2000 Investment Benchmark Report”, published by Venture Economics, 2000.
PME has the advantage that it is simple to apply and provides a way to directly compare the performance of a private equity fund with the performance of a public index. However, while PME has received a good deal of academic publicity and has been used to a limited extent, PME has several drawbacks. As a result, it has not been widely embraced by the financial industry as a day-to-day measure, particularly in the context of rating and modeling prospective private equity offerings.
One drawback is that when the private equity fund is not liquidated and the net asset value (“NAV”) is different from zero at the end of the time interval, PME still has some dependency on the NAV. In such circumstances, using PME as a benchmark actually reduces to simply comparing the end balance of the index-tracking fund to the NAV of the private equity fund, setting a lot of emphasis on the latter number and relying indirectly on the assumption that the private equity investor can immediately exit the fund at that value. This assumption is questionable given the basic lack of liquidity of private equity.
A more significant issue is that PME does not always accurately reflect real-world results. For example, when a private equity investment outperforms the public index on which the benchmark is based, the resulting hypothetical investment in the index tracking fund is likely to be negative. To achieve this result, the hypothetical investor in the benchmark would need to sell all of the investment shares and then short additional shares to make up the difference. At a minimum, this can skew a benchmarking process based on the PME and result in errors in a correlation analysis. In a worst case, depending on the cash flow pattern, the negative balance can make it impossible to determine a discount rate that would bring the net present value of the benchmark investment to zero such that the IRR for the public fund would be undefined.
For example, FIG. 1A shows pooled cash flows for vintage year 1990 (dark bars) and S&P500 total return index (solid line) for the period 1990-2002. FIG. 1B shows pooled cash flows for vintage year 1990 (black bars) and the corresponding PME cash flows (gray bars). The reported private equity NAV the end of 2002 is $937 million, whereas the corresponding index-tracking fund balance amounts to $−1,545 million. The final NAV of the index-tracking fund is deeply negative, pointing at the short exposure in the index. Despite the large negative final cash flow, IRR can be computed and yields 19.3%, which on compares well with the 21.5% achieved with the private equity portfolio.
FIG. 2 shows the development over time of the numbers of index shares the benchmark portfolio as determined by PME of vintage 1985. The number of shares is negative from 1993 onwards. Over that period, the exposure of an investor in the benchmark portfolio is equivalent to running a short position in the index. The evolution of the cumulative total value (sum of all distributions and current net asset value) indicates how the exceptional performance of the late 1990's is actually working against the benchmark portfolio. The market decline in 2000 and 2001 then results in huge gains. This shift from a long to a short position spoils the benchmarking process, resulting in non-sensible situations. A further direct consequence of the short position is that a correlation analysis based on PME can give misleading results.
Based on a benchmarking analysis of several hundred private equity funds, the applicants have found that more than 20% of the funds in the private equity database generated short index exposure through the life of the investments and about 5% yielded cash flow patterns with undefined IRR. As a result, PME calculations, while useful for certain limited cases, can be unreliable in many situations, giving either incorrect results or being impossible to calculate. This makes it difficult to use PME as a consistent and long term measurement for private equity and other assets or liabilities with irregular cash flows.
It is an object of the invention to provide a method of comparing the performance of public and private equities and, more generally, for comparing any two asset classes where at least one has irregular cash flows or irregular performance, and which method avoids the problems associated with PME.
A further object of the invention is to provide an improved method for comparing the performance of different private equity assets.
In addition to benchmarking a current performance of a private equity asset for which data exists, there is also a need to determine the performance of a private equity asset, liability, or other asset having an irregular cash flow, relative to an index or other benchmark value under market conditions that differ from the conditions for which private equity data is available. Such an analysis can be used, for example, in trying to determine how well a given private equity asset would have performed at different periods in history. It can also be used to determine performance the private asset under various circumstances using a simulation process that varies a performance index so as to determine a probable range of behaviors for the asset. Unlike public equities, which have a long and detailed historic record, the record of private equity performance is more limited, spanning on the order of 20 years or so. As a result, there is little or no real private equity data under many different types of market conditions. Without real performance data, there is no direct measure under such market conditions that can be used to determine private equity performance during other time periods. Conventional practice has been to simply assume that private equity is correlated to public equity and so would have the same return as the benchmark. However, benchmarks typically represent the average performance of a large number of components while the particular private equity asset under consideration draws from a much smaller pool. Even if an overall average of private equity assets has a performance that closely tracks the index, half of the individual private equity assets would be expected to outperform the index and half to under perform the index. Thus, the usefulness of this conventional technique is limited to providing support for general statements about the asset class as a whole and does not provide insights on particular sub-sets.
What has been absent from conventional analysis is a technique to allow the use of a private equity data set that is valid for a first time period relative to a benchmark as the source for a derived data set for use in analyzing performance against the (historical or generated) benchmark over a second time period for which good private equity data is lacking. This would permit the accurate use of sophisticated data analysis techniques and tools, such as Monte-Carlo and historic simulation systems. These simulation systems have been developed for use in analyzing and predicting the behavior and comparative risk of investments in public equities or other more traditional assets for which there is a much longer set of market data for a much greater number of entities and for which performance data, such as pricing, is available on a comparatively continuous basis during that time span.
One known technique for risk analysis of private equity is disclosed in Published U.S. Patent Application 2003/0028463A1, entitled “Process and System for Determining Correlation of Public and Private Markets and Risk of Private Markets,” dated Feb. 6, 2003. This application discloses determining a risk associated with private equity investments by performing a correlation analysis between the IRR of the private equity and a corresponding IRR calculated using conventional PME as applied to a public market index. The coefficient of correlation between the IRR of the private equity and that from PME is then used to determine a value for risk vs. return of investment in the private equity relative to that of investing in the public market.
There are several drawbacks to this approach. The disclosed method is inaccurate because it relies on PME, which gives flawed results under a number of circumstances. For example, the disclosed method does not properly address situations where the PME may produce a negative IRR under circumstances where analysis of the benchmark index would give the expectation of positive results. Also, even if only the difference between the IRR for the private equity and from PME is considered, there may still be situations where the IRR in a PME analysis is undefined so that the disclosed technique breaks down. In addition, the application does not address issues raised by the absence of private equity data in time periods before the 1980s. Instead, the disclosed technique uses the same correlation analysis based on the available private equity data regardless of the time period from which the public market data is drawn for the PME calculations. Although a mathematical value can be determined through this analysis, it does not account for the fact that the private equity behavior would likely be different under different market conditions. Thus, for example, while the disclosed correlation analysis can provide an indication of the risk of investing in a private equity today relative to the risk of investing in the S&P in 1940s, the usefulness of this value is questionable. The real issue is to determine a comparative risk of investments made at the same time under the same market conditions. This is not addressed in the application referenced herein and, indeed, the application indicates that other than the disclosed correlation analysis, there was no way known to the named inventors, who are also early developers of PME, to evaluate the comparative risk of a private investment portfolio.
U.S. Patent Application Publication 2003/0061169A1, dated Mar. 27, 2003, discloses a method and system for evaluating the performance attribution of a private investment portfolio. The disclosed technique relies on converting the portfolio, which may contain investments of different amounts in different private equities, into a neutral-weight portfolio. This is done by scaling the cash-flows of all investments in the portfolio, in their entirety, to a common constant so that the contributions of each investment to the portfolio are equally weighted. Because the relative weights of each component in the portfolio are equal, certain types of portfolio management calculations are simplified. However, this reference is entirely unconcerned with the problem of providing private equity data suitable for use in analysis relative to an index during a period in which actual private equity data is unavailable.
It is a further object of the invention to provide a method of scaling private equity cash flows and performance so that a performance attribute of the scaled cash flows has a specified relationship to an observed index or benchmark or a simulated index or benchmark and where the scaling allows application of existing private equity data to analysis and simulation of the private equities for periods where actual data is not available.
Another object of the invention to provide a method of scaling private equity cash flows and performance to match a given performance for use in historical, Monte-Carlo, and/or other types of simulation.
A further object of the invention to provide a method of determining various sets of cash flows, performance or scenarios achieving a determined return for use in generated future performance simulation (prescribed or randomly generated).
Yet another object of the invention is to provide a method of scaling private equity cash flows and performance for use as part of a rating analysis of a structured product.
Yet a further object of the invention is to provide a method of scaling private equity cash flows and performance for use as part of a rating analysis of a debt product based on assets/liabilities of alternative assets.
Still another object of the invention is to provide a method of scaling private equity cash flows and performance for risk modeling, control and management of such assets/liabilities.
Still a further object of the invention is to provide a method of scaling private equity cash flows and performance for portfolio management of such assets/liabilities, whether by themselves or as part of a larger portfolio of assets/liabilities containing other assets.